What Is an Inverted Spread?
The term inverted spread refers to a situation in which the yield for a longer-term financial instrument is less than a shorter-term instrument. In effect, a shorter-term instrument yields a higher rate of return (RoR) than a longer-term one. This is in contrast to normal market conditions, where longer-term instruments yield higher returns to compensate for time.
This spread is calculated by subtracting the longer term from the shorter term. Inverted spreads between short-term and long-term U.S, Treasury notes or bonds commonly indicate that a recession may be on the way.
- An inverted spread occurs when the yield on a short-term financial instrument is greater than that of a long-term one.
- This spread is calculated by subtracting the long-term yield from the short-term yield.
- Investors expect longer-term instruments to pay more because they're required to keep their money in for a longer period of time.
- When short-term yields are greater, it indicates that investors are losing confidence.
- Short-term yields that are larger than long-term on U.S. Treasury bonds often indicates a recession is looming.
Understanding Inverted Spreads
The yield on long-term financial instruments generally tends to be higher than short-term ones. For instance, 10-year U.S. Treasury bonds yield a higher return than two-year bonds. But there are situations that arise when the reserve happens—when the yield on short-term instruments is higher than long-term ones. So the two-year bond yields more than a 10-year one. This is what is known as an inverted spread.
Investors expect a higher yield if their money is tied up for a longer period of time. They assume shorter-term instruments have a lower yield. By contrast, a higher yield is considered the payoff that the investor gets for committing their resources for an extended period of time. That's why an inverted spread is considered an abnormal scenario and is undesirable.
U.S. Treasury note yields are often the most obvious—and the easiest—to track and compare. You can contrast the yields of notes on the shorter end of the maturity spectrum, such as those with one-month, six-month, or one-year terms against those with terms of longer durations, such as 10-year bonds.
It is easy to determine the yield spread between two financial instruments and identify whether it results in an inverted spread. You can calculate the spread using simple subtraction, given the yields of the two instruments involved. So in order to determine the spread, subtract the long-term yield from the short-term one. If the latter is larger, you end up with an inverted spread.
The difference between the long- and short-term yields don't necessarily have to be a negative number in order to result in a yield spread. The short-term yield just has to be larger than the long-term yield.
A spread that trends in an inverted direction can sometimes be a red flag for a recession and generally indicates that investor confidence in the short-term outlook is dropping. In fact, every major recession in the United States since 1950 came after the market experience inverted spreads.
Investors may feel more comfortable with the prospect of longer-term instruments and are usually less anxious to invest in short-term securities. As a result, issuers must offer a higher yield as a way to attract investors and motivate them to overcome their feelings of trepidation. Otherwise, many investors would instead just opt to go with longer-term bonds.
Example of an Inverted Spread
In the bond market, if you had a three-year government bond yielding 5% and a 30-year government bond yielding 3%, the spread between the two yields would be inverted by 2%. This is calculated by subtracting the 3% yield from the 5% yield. The reasons behind this situation can vary and can include changes in the supply and demand of each instrument and the general economic conditions at the time.